U.S. Shale Is Determined Not To Kill This Rally

Oil prices moved closer to a two-month high on Friday, closing out the week with some of the strongest gains in 2017. Market sentiment has turned “cautiously optimistic,” as Goldman Sachs put it, with rebalancing efforts starting to become more clear.

Crude oil inventories continue to decline, and the latest EIA figures show a massive 7.2 million-barrel drawdown for the week ending on July 21, suddenly plunging U.S. inventories back into the upper end of the five-year average range. Data from the past month or so has dispelled fears that the oil market was poised to suffer another meltdown, perhaps below $40 per barrel.

Instead, Brent is back up above $50 per barrel for the first time in two months, and WTI is hovering just below that range as well.

"While OPEC's production path remains uncertain, recent fundamental oil data have come in even better than we had expected," Goldman said in a research note last week. "If sustained, these trends would help achieve the normalization in inventories by early next year."

Goldman also says that inventories are declining not just in the U.S., but around the world. The investment bank says a combined 83 million barrels have been pulled out of storage in Europe, Singapore, Japan and the U.S.

Goldman projects that continued drawdowns could push the oil futures market into a state of backwardation, which the bank has consistently said would be necessary in order to achieve the “rebalancing” that OPEC has long sought. Backwardation – a state in which near-term oil futures trade at a premium to contracts further out – would make storage uneconomical, forcing more rapid drawdowns. It would also scare away shale drilling to some degree, if drillers saw future-dated oil prices lower than they are today. Moreover, Wall Street might be reluctant to lend a lot of money to indebted shale drillers for the same reason, growing skittish if they see that prices might decline over the course of a year or two.

The shale industry has repeatedly drilled itself into a whole, deploying rigs at such a frenzied pace that they have killed off several oil price rebounds. This time, perhaps, might just be different. Investors are a bit more cautious, pressuring companies into slashing spending and improving profitability. Last week we saw a flurry of spending cuts, from Anadarko Petroleum, Whiting Petroleum, ConocoPhillips and Hess Corp. More are likely in the offing.

That occurred because many companies have questionable economics at today’s oil prices, despite the boasts of so many shale executives over the past few years. "Most investors shared our view that U.S. onshore growth is unsustainable in the $40-$45/bbl price environment and that activity would need to be reduced to better balance corporate cash flows and" spending, according to analysts with investment firm Stifel. "Our end conclusion is we need less rigs and more capital discipline."

Other analysts have come to the same conclusion. "By prioritizing production growth over profitability and margins, investors and producers are at risk of killing their goose before it lays a golden egg," Benjamin Shattuck of Wood Mackenzie said in a recent report. Related: Aggressive U.S. Oil Sanctions Could Bankrupt Venezuela

The latest oil price downturn in June might have finally sent the message to oil executives that the appearance of a sudden price rally should not be trusted. The EIA recently revised down its growth projects for U.S. oil production in 2018 from 10.0 million barrels per day to 9.9 mb/d.

Meanwhile, Goldman says that while the Permian Basin has been hot for a while, it is finally starting to differentiate itself from the rest of the shale industry, for two reasons. New frac sand mines are being proposed in close proximity to shale drillers in the Permian, which could lower well costs by as much as 5 percent, translating to lower breakeven prices by about $1.50 to $1.75 per barrel. Second, Goldman says productivity improvements in the Permian are likely to be at the upper end of its forecast 3 to 10 percent.

As such, Permian drillers will probably continue to proceed with their growth plans, although the exuberance with which they do it is starting to calm. Having been hit by so many false rallies, the shale industry is finally starting to show some restraint.

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Try to tell that to the EIA. They were already >200k of daily production high in their estimates based on the most recent confirmed data for April. They don't seem to care though and keep ramping up their fudged production numbers.